Diamond Shares: Tasty or Nuts?

By Jack Hough

A June column in this space warned readers about Diamond Foods (DMND) shares. Its business looked attractive but the shares had simply gotten too expensive. Since then, they have lost more than half their value — but the plunge is related to questions over the company’s accounting.

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Is this an opportunity for bargain hunters, or a trap?

Diamond’s products offer a rare mix of recession resistance and growth potential. Its namesake culinary nuts are just the sort of thing consumers continue buying when budgets get tight. (Fewer trips to restaurants, after all, mean more meals cooked at home.) And its salty nuts (Emerald) and chips (Kettle) offer exposure to one of the fastest-growing food categories: snacks.

But the appeal wasn’t lost on investors, who flocked to consumer staples shares earlier this year. In June, Diamond’s stock fetched 28 times earnings, about double the broad market’s price. That’s the sort of valuation more commonly associated with blazing-growth dotcom firms, not food sellers.

In recent months, questions over the company’s walnut accounting have sent shares skidding. As The Wall Street Journal reported Monday, some walnut growers are questioning mysterious payments made by Diamond in recent months. The company’s fiscal 2011 ended July 31, and some growers say they received below-market payments for last year’s crop, followed by unexpected checks in the current fiscal year, according to the report.

The company calls recent payments an advance on the fiscal 2012 crop — “momentum” checks to help growers smooth out their cash flow. Some see things differently, including Mark Roberts of Off Wall Street Consulting Group, which specializes in short-selling research. According to a November report by Barron’s, Mr. Roberts believes the company made payments this year to top off growers who were underpaid last year. Such a scheme would run afoul of accounting rules that require expenses to be booked when they’re incurred.

Worse, Diamond has planned a mammoth acquisition of Pringles potato chips from Procter & Gamble (PG), mostly in exchange for stock. That leaves the company exposed to accusations that its walnut mix-up boosted its earnings ahead of the deal.

A spokeswoman for Diamond declined to comment. On Monday, the company announced that an ongoing investigation will delay its quarterly financial report. Its stock had jumped more than 50% Friday on an analyst report saying the matter is likely to be cleared up quickly. Early Monday it slid 20%.

Thilo Wrede, who covers the stock for Jefferies & Company, an investment bank, wrote last month that management is guilty of poor communication, but not likely anything more.

For contrarian investors considering a purchase of the stock, the first thing to consider is the price. It sells for 11 times forecast earnings for fiscal 2012, which would be a handsome deal if earnings forecasts could be relied upon. They can’t, until more is known.

Mr. Wrede reckons the stock is worth $39 a share, or $7 a share more than it recently sold for, based on a “worst case scenario.” That includes the Pringles deal falling through (at this point, the purchase price is nearly three times Diamond’s stock market value), triggering a $60 million break-up payment in the current fiscal year. It also includes an investigation that costs $15 million a year through fiscal 2015.

However, Mr. Wrede also cautioned that the stock could trade well below his target price before the accounting questions are resolved.

All told, there seems little reason to chase Diamond shares for now. Long-term investors rely upon fundamental measures of company prosperity to make their decisions. If there are questions about those measures, even if the answers seem innocent, investors should demand the deepest of discounts to make up for the uncertainty.

Diamond’s discount doesn’t seem big enough. For example, forgetting about expenses and earnings, it sells for 0.7 times revenues. That’s merely average for packaged food companies.

Moreover, for investors, the opposite of trust is a cash dividend. Diamond pays less than 10% of its profits to shareholders as dividends. The stock’s yield is just 0.5%. That gives investors precious little to look forward to while waiting to learn more about the walnuts.

A previous version of this story featured a photo of a Blue Diamond Growers product, which is not associated with Diamond Foods.

A previous version featured a photo of XXXXX that is not associated with Diamond Foods.

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